USD Back to the Brink&hellip;Again

A volatile week brought July to a close and the USD finished out on the low side of ranges that have dominated currency markets for the last two months. We are reluctant to make too much of Friday's USD decline as it was likely heavily influenced by month-end portfolio hedging flows against a backdrop of reduced summertime liquidity. (As stocks in the US have risen in July, foreign asset managers need to sell more USD to hedge against higher US portfolio valuations.) After months of range-bound trading, FX markets are certainly overdue for a directional breakout. The overriding dynamic remains risk sentiment, and risky assets (stock, commodities, and JPY crosses) rebounded sharply in tandem with USD declines, potentially setting the stage for a USD breakdown/extended gains in the JPY crosses. However, we would note that the most of the USD lows for the year remain intact (AUD/USD high is the exception), as do the highs in the JPY crosses, despite new highs in most stock indexes. Last week, we cautioned that currencies were not confirming the risk embrace seen elsewhere, and while we maintain that view, we also have to reckon with a range breakout at some point. The start of the new month seems a fitting time and the data calendar offers several potential catalysts, culminating with the July US NFP report on Friday, with an early hint coming from the ADP national employment report on Wednesday.

While a further extension of the risk rally may be imminent, we would not expect it to be exceptionally forceful after the initial break. Indeed, many of the likely data catalysts (e.g. July ISM manufacturing and automobile sales on Monday) are widely expected to improve, given gains in Chicago PMI and the success of the CARS (Cash for Clunkers) program, and this potentially sets up a "buy the rumor, sell the fact" reaction. In this regard, we would look to sell rallies in EUR/USD on the approach to 1.45, GBP/USD near to 1.70, and in AUD/USD near to 0.8500. At the same time, we will remain exceptionally alert to short-term reversals, using trailing stops to exit breakout positions on breaks of the year's highs or lows. In light of stock markets potentially having gotten ahead of the economic recovery curve, official concerns over currency strength in Australia, New Zealand, Canada, Japan, Switzerland, and to a lesser extent, Europe and the UK, and the high degree of uncertainty in the overall economic outlook, we still think markets are prone to two-way traffic, rather than a one-way adjustment in prices.

US Economy Showing Signs of a Pulse

US 2Q GDP came in better than market expectations at -1.0%, but this was at the expense of a much worse 1Q number, which was revised to -6.4% from -5.5%. The guts of the report were a story of second derivative improvement. In other words, it showed that things are "less bad." The drop in imports was -15.1%, compared with a -36.4% drop the prior quarter, while exports fell a more modest -7.0% after plunging -29.9% previously. Business spending also declined at a much slower rate, falling -9.0% after a dreadful -36.4% print.

The one rub was personal consumption, which fell a sharper-than-anticipated -1.2% after rising a modest 0.6% in 1Q. This was despite so-called "stimulus measures" from the government and suggests that the consumer remains focused on balance sheet repair. The news that the recession has actually been worse than previously reported was old news, but quite telling of the mess we were in nonetheless. The third quarter of 2008—when the financial crises accelerated in earnest—saw growth revised down to a dismal -2.7% from a prior add of 0.5%, for example. We are inclined to think that the current recession ended in late 1Q09 to early 2Q09 and look for positive growth towards the back end of this year. That is not to say growth will be anything close to robust, as consumer spending is likely to stumble along.

In a turning point environment, high-frequency data will become even more important to track. This week brings US non-farm payrolls, auto sales, and the ISM manufacturing index. These are all more timely indicators of the health of the US economy than the backward-looking GDP report. Success of the "cash for clunkers" program was evident in the better Chicago PMI report, and this could trickle through to higher ISM and vehicle sales numbers. Employment, however, remains a thorn in the side of the economy, and the fact that weekly initial claims improved only by 57K, on average, in July suggests another downright ugly NFP number could be in the works. So while early-week data could see the risk rally resume, the employment report could prove to be a reality check ahead of the weekend.

BoE MPC: Market Speculates on the Future of QE

An improvement in UK mortgage lending, coupled with survey data from the Nationwide suggesting three consecutive months of housing price increases, and the ability of consumer confidence to hold at its best level since April 2008 all support the view that the BoE will announce no increase in its QE program following its policy meeting on August 6. The Bank announced on July 30 that it had completed its GBP 125 billion leg of its asset purchase program, involving gilts. It has been granted permission by the government to extend this by another GBP 25 billion, and given the possibility that the economy may yet take a turn for the worse, it is unlikely that the Bank will rule out potentially fulfilling this quota in the months ahead. Of note is that the BoE announced on July 30 that it will begin to buy short-term debt from companies on August 4. This appears to be addressing directly concerns that extra liquidity is still not getting from the banks to where it is really needed. This also signals that the BoE is steering its asset-purchasing plan in a fresh direction. More on this could be heard on August 6. News that the QE program will be extended would weigh on sterling. Similarly, confirmation that the Bank will not immediately be extending QE could give sterling a fillip and push cable up to its range highs around 1.6600. In view of the pound's underlying fiscal concerns, we would expect to see sellers above the 1.6600 area, with scope back towards the 1.6450 area initially.

NEXT: ECB Meeting Outlook, Key Data to Watch This Week
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ECB Meeting: "Enhanced Credit Support" the Focus

The ECB is not expected to change the value of it refinance rate (1%) possibly well into 2010. Potentially more interesting will be any references to the outlook with respect to its "enhanced credit support" plan. Recent comments from the ECB's Papademos confirm that the ECB has committed itself to continuing with the fixed-rate tender procedures for all the main and supplementary refinance operations for at least beyond the end of 2009. This enables banks to borrow unlimited funds at 1%. The ECB will also continue with its relatively modest covered bond purchasing plan (EUR3.8 billion have been bought so far). There is some evidence that the ECB's policies are having an impact as three-month euribor has trended lower. However, ECB lending data are yet to show a significant improvement. Lending to companies and households continued to tighten in Q2, albeit at a reduced rate than in Q1, which suggests that banks are yet to pass on the additional liquidity afforded to them from the ECB. Inflation forecasts may also worry the ECB. A European Commission survey suggests that consumers increasingly expect prices to fall in the year ahead. The German inflation rate fell to -0.6% y/y in June, though to date, the ECB rhetoric has maintained that inflation is in line with its projections. Given the weak price data and still soft lending data, some speculation is emerging that the ECB will consider additional credit support measures at the August policy meeting such as the purchasing of commercial paper. It is likely that the ECB policy meeting will have no significant impact on the EUR, however, any change in rhetoric by the ECB exposing increased concerns about deflation could undermine the EUR.

Key Data and Events to Watch This Week

The US calendar has a few top-tier numbers on deck in the week ahead. ISM manufacturing, auto sales, and construction spending kick off on a busy Monday. Personal income/spending and pending home sales are up on Tuesday, while Wednesday is also busy with the ADP employment report, ISM services, and factory orders lined up. Thursday has the usual jobless claims data, while Friday rounds out the week with the all-important non-farm payrolls report.

It is a pretty eventful week in the euro zone as well. Monday starts it off with German retail sales and euro zone PMI manufacturing indices. Euro zone producer prices are due on Tuesday, while Wednesday has euro zone PMI services and retail sales. Thursday is the highlight as the ECB meets on interest rates (more above) and we'll also see German factory orders. Friday closes out the week with German trade, French trade, and German industrial production.

The UK also has an important week lined up. Monday has PMI manufacturing, while Tuesday brings consumer confidence. Wednesday is busy with PMI services, industrial production, and the NIESR GDP estimate for July. The BOE is scheduled to meet on rates Thursday (analysis above), while Friday has producer prices on tap.

Japan is ultra light and vehicle sales on Monday and the leading economic index on Thursday are the only noteworthy releases.

It is similarly slow in Canada. The data come in the latter part of the week with building permits on Thursday and the Ivey PMI and employment report on Friday.

The agenda is a touch busier down under. Australian retail sales and home prices kick off the action on Monday. Tuesday has the highlight with the RBA rate meeting on deck along with the Australian trade balance. Wednesday brings both the New Zealand and Australian employment reports, while Thursday rounds out the week with the RBA Quarterly Monetary Policy Statement.